FOOL ON THE HILL: An Investment OpinionA Look at Return on Invested Capital

Longtime Fool Community member Andrew Chan steps up on the Hill today to discuss a highly important topic of valuation -- return on invested capital (ROIC). This builds upon his significant work on the subject for the McGill Investment Club, which he made available to other Fools through a free download.

Return on invested capital, or ROIC, is one of the most fundamental financial metrics. But despite its importance, it does not receive the same kind of press coverage as earnings per share (EPS), return on equity (ROE), and the price-to-earnings ratio (P/E). One reason is probably because you cannot obtain ROIC straight out of financial statements. Nevertheless, the concept is fundamental in measuring how much value a company creates.

So what exactly is ROIC? It is defined as the cash rate of return on capital that a company has invested. It is the true metric to measure the cash-on-cash yield of a firm and how effective it allocates capital:

ROIC = Net Operating Profits After Taxes / Invested Capital

Net Operating Profits After Taxes (NOPAT), the numerator, is perhaps the best metric to measure the cash generated by operating activities. It is better than net income because it excludes items such as investment income, goodwill amortization and interest expense, which are non-operating in nature.

For example, in its 2000 fiscal year, Cisco(Nasdaq: CSCO) had a net income of $2.7 billion, however more than $600 million (after-tax) was generated from investment income. Obviously, Cisco's net income is not very representative of the profitability of its operations. Once adjusted to reflect operating activities, Cisco's NOPAT amounted to $2.3 billion (goodwill was added back). NOPAT focuses on operations, which is why it is a better measure than net income and EPS. Fools do not invest in companies for their ability to generate investment income, but for the profitability of their core operations. The simplified formula to calculate NOPAT is as follows.

As for invested capital, the denominator, it represents all the cash that debtholders and shareholders have invested in the company. Invested capital can be calculated by subtracting cash and equivalents and non-interest bearing current liabilities (NIBCLs) from total assets. Cash is being subtracted because it does not yet represent operating assets. As for NIBCLs, which include accounts payable, income tax payable, accrued liabilities, and others, they are subtracted from capital because they bear absolutely no cost (interest-free). Note that to calculate ROIC, we use the average invested capital for the period.

Before I move on with further insights on ROIC, another concept must be introduced: the weighted average cost of capital (WACC). For without the WACC, ROIC is not very useful. The WACC represents the minimum rate of return (adjusted for risk) that a company must earn to create value for shareholders and debtholders. ROIC is measured against the WACC, which is what makes it such an important concept.

When the ROIC is greater than the WACC, it means that the firm creates value; otherwise it destroys value. In practice, a company with a ROIC of 25% and a cost of capital of 11%, has created 14 cents of pure economic value for every dollar invested. The difference between ROIC and WACC is called the ROIC-WACC spread (%), which is one of the most important valuation tools in securities analysis (For more information on the WACC, please read Dale Wettlaufer's Equity Isn't Free).

So what does all this mean for investors? To start with, Fools would be better off tracking ROIC-WACC spreads than EPS, net income or ROE. Studies have shown that stock prices are highly correlated with ROIC-WACC spreads. Value creation is the key, simply looking at EPS or net income does not indicate whether a company creates value or not. In some cases, even high sales growth can be harmful as new capital is being invested in value-destroying projects. EPS, net income, and growth does not tell how much capital was required to generate those numbers, which is a fundamental flaw in using these traditional metrics.

ROIC can also be used to understand why stocks trade at different multiples, whether we are talking about P/E, enterprise value/invested capital (EV/IC), or price-to-book value. The P/E ratio is not only a function of growth, but also ROIC. The market is perhaps the best example of such a relation. From 1995 to 1998, the S&P 500's P/E ratio increased from 15 to 25. Many analysts and market gurus were screaming loud and clear that the market was overvalued because it was trading at a premium multiple to its historical level. However, the reality is that while the P/E ratio expanded, there was also a significant rise in the market's ROIC as it rose from 15.5% to 25.5% (Source: CSFB, The Fat Tail That Wags the Dog). A high P/E ratio does not mean that a stock is overvalued, but simply that it is more valuable.

Perhaps one of the best growth and value creation stories I have seen so far is Network Appliance(Nasdaq: NTAP). From 1998 to 2000, Network Appliance grew its sales from $166 million to $579 million (88% annual growth). In the mean time, its ROIC increased from 44.6% to 57.3%, which is quite an achievement. In 2000, Network Appliance's cost of capital was around 18.2%, which means that its ROIC-WACC spread was an impressive 39.1%. Consequently, the stock has increased more than 2,400% since 1998.

Of course, we can't attribute the stock appreciation to a stellar ROIC alone. However, it was a major factor as we don't see many stocks with rising ROICs, especially at such a high level. In fact, economic theories predict the opposite: ROICs are expected to decline as competition eats up economic profits. Network Appliance's feat is even more impressive when we consider that there is a 500-pound gorilla named EMC(NYSE: EMC) in the storage industry. By the way, EMC's ROIC was 43.7% (annualized) for the first six months of 2000, which is considerably lower than Network Appliance's.

ROIC is a valuable tool to assess the quality of a company. Generally speaking, companies with higher ROICs are more valuable. While I do not pretend that it solves all questions related to valuation, it is nevertheless a strong improvement over EPS and net income. It is important for Fools to understand that it is not only the level of ROIC that matters, but also the trend. A declining ROIC may be an advanced indicator signaling that a company is having a hard time dealing with competition. On the other hand, an increasing ROIC may indicate that a company is distancing its competitors or that it is being more efficient at deploying capital.

In this article, I have introduced the concept of ROIC, which is at the foundation of the Economic Model. The methodology I have presented was simplified. For those who want to learn more about the mechanics of ROIC, I have provided Fools with my own 30-page report, The Mechanics of the Economic Model, as well as a spreadsheet using Oracle(Nasdaq: ORCL) as an example. Both documents can be downloaded here for free. My report is based on the readings below that I strongly recommend and on Bennett Stewart's Quest for Value.